Up and Running: Treasury Publishes Final Rules for Outbound Investment Security Program

Following years of development, on October 28, 2024, the U.S. Department of the Treasury published a final rule establishing its outbound investment security program (Final Rule).  The new regime prohibits certain outbound investments to China and requires notifications to the United States government for others. The rule will become effective on January 2, 2025.

The tenets of this new regime are outlined below. Investors should keep several items top of mind; most notably, attention to the following considerations will be key:

• U.S. employees of non-U.S. persons with executive authority may have affirmative and individual compliance obligations; and
• A wide variety of transaction structures, including direct and indirect transactions, may trigger notification obligations or be prohibited.

The Final Rule seeks to clarify, resolve points presented as options, and, in some cases, narrow several areas from the proposed rule from earlier this year, but the fundamental substance has changed little: the three applicable sectors (semiconductors, quantum, AI), the types of transactions covered, and which transactions broadly are prohibited and which require notification.

At its core, the Final Rule expects U.S. persons to obtain and maintain “knowledge” about the companies in which they invest—directly or indirectly—and act based on that knowledge. The Final Rule expects that this “knowledge” will be acquired through new and current kinds of diligence on investment targets’ specific technical capabilities and business plans. The Final Rule then expects that parties will accept potentially having to back out of prohibited transactions after diligence or that parties will further cooperate in the collection and disclosure of that information to the U.S. government. Whether and the extent to which the market tolerates these new expectations is a key question going into 2025.

I. Program Overview

The Final Rule prohibits certain U.S. investments in covered foreign persons engaged with:

• Advanced semiconductors and microelectronics, including development or production of electronic design automation software, certain fabrication or advanced packaging tools, and items designed for use in extreme ultraviolet fabrication; the design or fabrication of certain advanced integrated circuits; advanced packaging techniques for integrated circuits; and supercomputers.
• Quantum information technologies, including the development of quantum computers or production of any critical components required to produce a quantum computer; the development or production of certain quantum sensing platforms designed or intended for military, intelligence, or mass surveillance use; and the development or production of certain quantum networks or quantum communication systems.
• Artificial intelligence (AI) systems, including any AI system designed to be exclusively used for, or intended to be used for, military end use or government intelligence or mass-surveillance end use and any AI system that is trained using a quantity of computing power greater than 10ˆ25 computational operations, or trained using primarily biological sequence data and a quantity of computing power greater than 10ˆ24 computational operations.

The Final Rule requires notifications for certain U.S. investments in covered foreign persons engaged with:

• Semiconductors and microelectronics, including those related to the design, fabrication, or packaging of integrated circuits not otherwise covered by the prohibited transaction definition.
• AI Systems not otherwise covered by the prohibited transaction definition, where such AI system is designed or intended to be used for (i) any military, government intelligence, or mass-surveillance end use, (ii) cybersecurity applications; (iii) digital forensics or penetration testing tools; or (iv) the control of robotic systems, or when such AI system is trained using a quantity of computing power greater than 10ˆ23 computational operations.

The Final Rule also prohibits U.S. investments in a covered foreign person engaged in either notifiable or prohibited activities if the foreign person is included on U.S. “blacklists,” including the Entity List, Military End User List, OFAC Specially Designated and Blocked Persons (SDN) List, or non-SDN Chinese Military-Industrial Complex List.

As discussed in more detail below, transactions subject to outbound investment restrictions require four elements: (i) a “U.S. person,” (ii) a “transaction,” with (iii) a “covered foreign person” engaged in (iv) “covered activities.”  In addition to filling in details and providing color to the proposed regulations published earlier this year, the Final Rule fully develops the exceptions to the program, which are of significant interest to the investment community.

II. U.S. Persons

The obligations under the outbound investment program regulations apply to U.S. persons, which the Final Rule defines as (i) U.S. citizens, (ii) lawful permanent residents, (iii) entities organized under the laws of the United States or any jurisdiction within the United States, including any foreign branch of any such entity, or (iv) any person physically located in the United States.

U.S. persons are prohibited from knowingly directing a transaction by a non-U.S. person that the U.S. person knows at the time of the transaction would be a prohibited transaction if engaged in by a U.S. person.  The Final Rule narrowed the scope of this prohibition to clarify that it applies only to U.S. persons possessing executive authority in the non-U.S. person, and “knowingly directing” requires that the U.S. person both possess and exercise the authority in decision-making to approve a transaction.  This requirement, similar to the facilitation concept in U.S. sanctions, could apply when a U.S. person (i) has authority, individually or as part of a group, to make or substantially participate in decisions on behalf of a non-U.S. person (as an officer, director, or someone otherwise possessing executive responsibilities at a non-U.S. person), and (ii) exercises that authority to direct, order, decide upon, or approve a transaction.

Despite this potential jurisdictional hook, a U.S. person serving as an officer, director, or executive can avoid the implications of this obligation if they are recused from each of the following activities:

• Participating in formal approval and decision-making processes related to the transaction, including making a recommendation on the transaction;
• Reviewing, editing, commenting on, approving, and signing relevant transaction documents; and
• Engaging in negotiations with the investment target (or, as applicable, the relevant transaction counterparty, such as a joint venture partner).

III. Transactions

Transactions subject to the regime’s regulations (i.e., covered transactions) consist of a U.S. person’s, direct or indirect:

• Acquisition of an equity interest or contingent equity interest;
• Provision of a loan or a similar debt financing arrangement;
• Conversion of a contingent equity interest into an equity interest;
• Acquisition, leasing, or other development of operations, land, property, or other assets in a country of concern that the U.S. person knows at the time of such acquisition, leasing, or other development will result in, or—in a narrowing from the proposed rule’s reference to “intent”—that the U.S. person plans to result in:

1. The establishment of a covered foreign person; or
2. The engagement of a person of a country of concern in a covered activity;

• Entrance into a joint venture, wherever located, that is formed with a person of a country of concern, and that the subject U.S. person knows at the time of entrance into the joint venture that the joint venture will engage, or plans to engage, in a covered activity; or
• Acquisition of a limited partner or equivalent interest in a venture capital fund, private equity fund, fund of funds, or other pooled investment fund (in each case where the fund is not a U.S. person) that a U.S. person knows at the time of the acquisition likely will invest in a person of a country of concern that is in the semiconductors and microelectronics, quantum information technologies, or artificial intelligence sectors, and such fund undertakes a transaction that would be a covered transaction if undertaken by a U.S. person.

IV. Covered Foreign Persons

To fall under the outbound investment program’s jurisdiction, a transaction must involve a covered foreign person. The regulations define covered foreign persons as entities or individuals engaged in a covered activity and are:  

• An individual that is a citizen or permanent resident of the People’s Republic of China or the Special Administrative Regions of Hong Kong and Macau (and not a citizen or permanent resident of the United States);
• Any entity with a principal place of business in, headquartered in, or incorporated in or otherwise organized under the laws of the People’s Republic of China or the Special Administrative Regions of Hong Kong and Macau;
• The governments of the People’s Republic of China or the Special Administrative Regions of Hong Kong and Macau, including any political subdivision, political party, agency, or instrumentality thereof; any person acting for or on behalf of the government of a country of concern; or any entity with respect to which the government of a country of concern holds individually or in the aggregate, directly or indirectly, 50 percent or more of the entity’s outstanding voting interest, voting power of the board, or equity interest, or otherwise possesses the power to direct or cause the direction of the management and policies of such entity;
• An entity in which one or more persons identified above, individually or in the aggregate, directly or indirectly, holds at least 50 percent of the outstanding voting interest, voting power of the board, or equity interest; or
• Any individual or entity that directly or indirectly holds a board seat on, a voting or equity interest in, or any contractual power to direct or cause the direction of the management or policies of any individual or entity described above from or through which it: 

1. Derives more than 50 percent of its revenue individually, or as aggregated across such persons from each of which it derives at least $50,000 (or equivalent) of its revenue, on an annual basis;
2. Derives more than 50 percent of its net income individually, or as aggregated across such persons from each of which it derives at least $50,000 (or equivalent) of its net income, on an annual basis;
3. Incurs more than 50 percent of its capital expenditure individually, or as aggregated across such persons from each of which it incurs at least $50,000 (or equivalent) of its capital expenditure, on an annual basis; or
4. Incurs more than 50 percent of its operating expenses individually, or as aggregated across such persons from each of which it incurs at least $50,000 (or equivalent) of its operating expenses, on an annual basis; or

• Joint ventures with any individual or entity of China engaged in covered activities.

V. Covered Activities

Only transactions involving covered foreign persons engaged in covered activities are subject to the outbound investment program.  The regulations define covered activity to mean, in the context of a particular transaction, any of the activities referred to in the definition of notifiable transactions or prohibited transactions, which are for prohibited transactions:

• Advanced semiconductors and microelectronics, including development or production of electronic design automation software, certain fabrication or advanced packaging tools, and items designed for use in extreme ultraviolet fabrication; the design or fabrication of certain advanced integrated circuits; advanced packaging techniques for integrated circuits; and supercomputers.
• Quantum information technologies, including the development of quantum computers or production of any critical components required to produce a quantum computer; the development or production of certain quantum sensing platforms designed or intended for military, intelligence, or mass surveillance use; and the development or production of certain quantum networks or quantum communication systems.
• Artificial intelligence (AI) systems, including any AI system designed to be exclusively used for, or intended to be used for military end use or government intelligence or mass-surveillance end use, and any AI system that is trained using a quantity of computing power greater than 10ˆ25 computational operations or trained using primarily biological sequence data and a quantity of computing power greater than 10ˆ24 computational operations.

And for notifiable transactions:

• Semiconductors and microelectronics, including those related to the design, fabrication, or packaging of integrated circuits not otherwise covered by the prohibited transaction definition.
• AI Systems not otherwise covered by the prohibited transaction definition, where such AI system is designed or intended to be used for any military end use or government intelligence or mass-surveillance end use, cybersecurity applications, digital forensics tools, penetration testing tools, or the control of robotic systems, or such AI system is trained using a quantity of computing power greater than 10ˆ23 computational operations.

VI.  Exceptions

The subject of considerable discussion and speculation, the Final Rule outlines the full scope of outbound investment program’s exceptions.  Noteworthy exceptions include:

• Publicly traded securities: Investments in a publicly traded security or a security issued by a registered investment company, such as an index fund, mutual fund, or exchange-traded fund;
• Certain LP investments: Investments made as a limited partner in a venture capital fund, private equity fund, fund of funds, or other pooled investment fund, if such investment is $2,000,000 or less or if the U.S. person has received a contractual assurance that its capital will not be used by the fund to engage in what would be a prohibited or notifiable transaction. So, based on this carveout and how covered transactions are defined, a U.S. limited partner’s investment in a pooled fund that makes investments in covered activities may be covered unless (i) the fund is itself a U.S. person, (ii) the limited partner’s investment in the fund is $2,000,000 or less, or (iii) the fund manager provides contractual assurances that the capital will not be used for covered activities.
• Derivatives: Investments in certain derivative securities;
• Buyouts of country of concern ownership: A full buyout of all country of concern ownership of an entity, such that the entity does not constitute a covered foreign person following the transaction;
• Intracompany transactions: An intracompany transaction between a U.S. person and its controlled foreign entity to support operations that are not covered activities or to maintain ongoing operations with respect to covered activities that the controlled foreign entity was engaged in prior to January 2, 2025;
• Certain Pre-Final Rule binding commitments: A transaction fulfilling a binding, uncalled capital commitment entered into prior to January 2, 2025;
• Certain syndicated debt financings: Where the U.S. person, as a member of a lending syndicate, acquires a voting interest in a covered foreign person upon default and the U.S. person cannot initiate any action vis-à-vis the debtor and is not the syndication agent;
• Equity-based compensation: A U.S. person’s receipt of employment compensation in the form of an award or grant of equity or an option to purchase equity in a covered foreign person, or the exercise of such option; and
• Third-country measures: Certain transactions involving a person of a country or territory outside of the United States may be excepted transactions where the secretary of the treasury determines that the country or territory is addressing national security concerns related to outbound investment and the transaction is of a type for which associated national security concerns are likely to be adequately addressed by the actions of that country or territory.

VII. Enforcement

The Final Rule, which goes into effect on January 2, 2025, also addresses the program’s penalty and disclosure framework. Violations of the outbound investment security program regulations are subject to civil and criminal penalties as set forth in the International Emergency Economic Powers Act (IEEPA).  In the event of a violation, Treasury is authorized to impose civil penalties and could refer criminal violations to the Department of Justice.  The maximum civil penalty for a violation is the greater of $368,136 (as adjusted annually for inflation) or twice the value of the underlying violative transaction.

Additionally, Treasury can take any action authorized under IEEPA to nullify, void, or otherwise require divestment of any prohibited transaction.  U.S. persons may submit a voluntary self-disclosure if they believe their conduct may have resulted in a violation of any part of the Final Rule, which will be taken into consideration assessing the disclosed activity.

VIII. Conclusion

Although the Final Rule comes after much publicity and public comment, the effect of this rule is far from clear. Is it a “tool in search of a problem,” or a critical blow to adversaries’ access to U.S. capital? Will the principal impact be unintended consequences on the competitiveness of U.S. investment capital in ancillary markets, or will this slow China’s development in critical and emerging technologies? 

Treasury may see a flood of notices, reflecting both clearly notifiable transactions and protective notices to deal with the rule’s ambiguities. Or one could see some U.S. investors avoiding the costs and risks by simply steering clear of the covered sectors. One could also see non-U.S. sponsors and managers simply avoiding U.S. capital in these sectors, rather than face the rule’s competitive and compliance risks. Both outcomes, however, seem to further the government’s goals of disrupting and learning more about whatever U.S. investment activity is still occurring in these areas. Ultimately, time will tell how the outbound investment security program plays out, but Treasury’s commitment to getting the rule finalized is another clear signal that the U.S. government remains committed to developing and expanding tools to further its national security policies.